1st Quarter - 2004 Investment Update
I have received feedback from my letters on a regular basis which I view as a wonderful development. After hearing some of the comments, I can’t help but believe some of you may be thinking of me as a perma-bear on stocks and on almost all other investments. I can assure you that I am not. I believe our country over the long-term is an ideal place to invest. It is the best place in the world, in fact. Thomas Friedman, op-ed columnist for The New York Times, said recently,
“America is the greatest engine of innovation that has ever existed, and it can’t be duplicated anytime soon, because it is the product of a multitude of factors: extreme freedom of thought, an emphasis on independent thinking, a steady immigration of new minds, a risk-taking culture with no stigma attached to trying and failing, a non-corrupt bureaucracy, and financial markets and a venture capital system that are unrivaled at taking new ideas and turning them into global products.”
I couldn’t agree more. But that is not to say investing in the U.S. financial markets is easy or that it does not entail risk. An understanding of these risks in relation to expected return is paramount in achieving investment success over the long-term.
Investment Commentary
When asset prices are low in relation to inherent value, the longer-term risk-reward ratio is asymmetrical. Simply said, this condition results in a significantly higher probability of gain than of loss per dollar invested. My view in the last year was that an investment in the general market could have best been characterized as providing investors with a 50% chance of a 10-15% gain and a 50% chance of a 30-40% loss. It doesn’t take a math major to understand the near impossibility of achieving sustained investment success under this type of condition. As a result, the investments in stocks being made on your behalf in the last year have not been representative of the risk in the general market. However, by and large, they have delivered returns in excess of the market (as defined by the S&P 500).
As always, we continue to do our best to buy stocks when their current price is substantially below our estimate of intrinsic value. In addition, most of you have not been fully invested in stocks over the last year as cash has been a significant holding.
It is our opinion that this greatly reduced the odds of experiencing a negative
long-term return.
I have been reading a great book called Against the Gods: The Remarkable Story of Risk written by Peter Bernstein. The book explores the origins of risk and the resulting leap into forecasting. It is not a topic that gets much attention but most great investors view investing in the context of probabilities. Warren Buffett has said that if given 3:2 odds on the flip of a coin he would wager a billion dollars. This may sound odd at first coming from the world’s greatest investor but in reality it makes perfect sense. Mr. Buffett has an acute awareness that success in investing, in gambling, or even in parlor games for that matter, hinges on having the odds in your favor (or, as in the case with gambling, at least having an understanding as to what extent they are not).
Successful investors choose not to play when there is a higher probability of loss than of gain. As I have said in previous letters, this does not mean they will be “right” in the short-term. They could be seen as being wildly “wrong.” One only has to recall the perceived demise of value investors in the late 1990’s in favor of internet investments to demonstrate this. However, over the long-term, whether investing, gambling, or playing a simple card game like hearts, if the odds favor you a desirable outcome will
likely result.
It is important to note that it is possible to have the “odds in your favor” when investing in securities like stocks. History has proven that astute value investors will have a much higher probability of success than a random investment program or an indexing approach. Rigorous fundamental analysis combined with other factors such as making investments in companies who have an industry advantage, stocks that may be trading at extremely low valuations due to investor misperception, or stocks that may have been sold for uneconomic reasons (spin-offs, S&P 500 deletions, etc.) will produce above-average returns. These types of investments are attractive precisely because risk has become low in relation to expected return.
Thank you very much for your continued confidence. As always, please call or write with any questions or comments.